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7 min read

How Does Equity Compensation Work?

Feb 22, 2022 4:00:35 PM

Money charts and graphs

Companies offer a wide range of employee compensation methods. Generous salaries, healthcare plans, and PTO are among the most common, but many companies also offer compensation that doubles as an incentive for high performance and long-term commitment. Equity compensation is just one example — but it takes a lot of different forms that are worth exploring.

These plans can be complex, and companies can help their employees by making sure they are taking a serious approach to understand them. When introducing them to your equity offerings, remind them that financial decisions are always deeply personal and that having clear goals in mind can help them work towards building their futures. They may also need to consult a tax professional to have a fuller view of some of the downstream impacts of their participation in your equity compensation plan.

Profit-Sharing vs. Equity Sharing

Beyond salaries and benefits packages, the most common types of employee compensation are offered through profit-sharing plans and stock options. The two plans are similar, but there are key differences to consider when it comes to how employees benefit.

How Profit Sharing Plans Work

The logic of a profit-sharing plan is simple: the more profits a company makes, the more a qualified employee can reap in rewards. This acts as a strong incentive for employees to do everything they can to increase the company’s profits. The sense of ownership inspired by a profit-sharing plan can also be a reward in itself.

When employees receive such a direct benefit from the success of the company, they are more likely to do their best work. From increased productivity to lower expenses, owners of a profit-sharing plan are highly motivated to help companies — and therefore themselves — succeed.

To administer profit-sharing plans, companies need to make decisions about how to qualify employees. Common criteria include:

  • Time with the company
  • Seniority levels (supervisor, manager, executive, etc.)
  • Performance reviews
  • “Special performance” incentives for outstanding achievement

Companies also need to consider how often to pay out profits. The balance to consider is that employees want to experience their rewards on a regular basis — but if the payout is too small within a given period, the benefit will feel underwhelming. An alternative to this more basic arrangement is profit sharing that gets rolled into a retirement-style plan. Similar to an IRA or 401(k), these deferred payments are designed to be accessed in the future.

How Equity Sharing Plans Work

Equity compensation operates with a similar ethos to a profit-sharing plan. But instead of a direct share of a company’s profits, employees are granted stock options. In this situation, it is not profits that serve as the incentive, but the value of the company stock. When an employee owns stock, they actually own a portion of the company. The more valuable the company becomes, the more valuable the ownership stake. Employees are therefore incentivized to invest themselves in the company for the long term.

The amount of equity compensation companies make available to employees is commonly set around 10% and made available only to executive leadership — but many companies set aside different percentages and offer stock options to all of their employees.

The same criteria used to determine who qualifies for profit sharing are also at play with equity compensation. However, companies are free to determine eligibility in any way that suits them — as long as employee stock ownership is an effective motivator to your workforce, incentive stock options can be a great way to get the most out of people no matter their seniority level.

Some challenges facing companies offering equity compensation include:

  • Accounting for growth requires companies to offer more equity
  • Decreasing share values leading to a less effective incentive
  • Understanding what happens to equity in the event that the company changes ownership

There are some key differences between profit sharing and equity compensation. Employees need to understand the vesting period of the stock, its expiration date, its tax benefits and liabilities, how to actually buy stock, and more. Stock value also changes over time — both for better and for worse — so it is important for employees to understand the associated risk of depending on that value as part of a retirement plan or for a future windfall.

Different Types of Equity Compensation

There are lots of different types of equity compensation plans, each with its own benefits and drawbacks. Below are just a few common examples.

Employee Stock Ownership Plan (ESOP)

More than 14.2 million employees take advantage of ESOPs, making these plans one of the most common forms of equity compensation. They work by having companies allocate stock into a trust directed toward individual employee accounts. When an employee leaves or retires, their stocks are released and they are then able to sell them back to the company. The stocks are regarded by companies not as an ownership stake, but as a part of their normal compensation — a cash contribution in exchange for an employee’s years of service.

ESOPs are typically available to all employees over the age of 21, and the vesting periods are highly regulated. The two options for setting vesting schedules are: (1) employees are not vested for 3 years, at which point they are fully vested; or (2) they are 20% vested at the beginning of their second year and gain 20% more each year until they reach 100%.

Research suggests that employees at an ESOP-based company go into retirement with more assets than average. ESOPs also have a favorable tax situation because taxes are only due at the time of distribution (as opposed to when the stocks are put into their accounts), and they are potentially taxed as capital gains. They could also be rolled into an IRA or another retirement account. Finally, for companies, they are completely tax-deductible.

But they are not without their drawbacks. Concentration risk is a big concern, and participants over the age of 55 who have been on the plan for 10 years are encouraged to diversify up to 25% of their portfolios.

Employee Stock Purchase Plan (ESPP)

When it comes to ESPPs, there is a pretty big gap between company offerings (75%) and employee participation (28%), which is attributed to employees’ perception that these plans are exceedingly complicated. But with a little primer on the subject, it may not be as hard to grasp as it might seem at first.

Essentially, ESPPs give employees the opportunity to purchase company stock at a discount. In some plans, discounts can go as high as 15% — but purchases cannot exceed $25,000 in a given year. Employees contribute as much or as little as they like (with limitations on the upside) by taking payroll deductions that add up over the years between the date the plan is offered and the date the stock is purchased. ESPPs also often have a “look back” provision, which allows employees to purchase plans either at the price it was at the time of offer or the price at the time of purchase — whichever is lower.

ESPPs are either qualified or non-qualified. Qualified plans can only be offered with shareholder approval. The offer period must be three years or less, and there are restrictions dictating how generous a discount can be. Non-qualified plans have fewer such restrictions.

These types of plans do have complex tax implications. For qualified plans, discounted stock purchases are taxed as ordinary income, with the remainder treated like long-term capital gains. Non-qualified plans are less advantageous, sometimes with the entire purchase taxed as ordinary income.

Employee stock ownership plan

Restricted Stock Units (RSU)

This decades-old option is available to both public and private companies and is the most common form of equity compensation awarded to all levels of employees. Restricted stock units are not purchased but awarded to employees — the contract gives employees the right to receive company shares according to a vesting schedule. Those shares are then granted in percentages over several years as an allotment. When the vesting conditions are met, they gain fair market value and are no longer restricted.

RSUs have a less favorable tax situation than some other forms of equity compensation. At time of vesting, the shares are taxed as ordinary income. This can be mitigated by the fact that any appreciation of shares is taxed at capital gains rates when they are eventually sold on the public market.

RSUs also present liquidity challenges — especially if the company is still privately held. IPOs can help by opening the stocks up to a larger market, but depending on the timing, participants might not be eligible to receive any benefit.

Employee Stock Options (ESO)

ESOs are commonly offered by start-ups or other fast-growing companies. This high-risk-high-reward stock option is designed to attract talent and retain employees. For a set period of time, employees can buy company stock at the “exercise price” — which is the price at which they can make a stock purchase, regardless of its future value. Employees make a profit off the shares as long as the current value is higher than the exercise price. If the current value is below the strike price, the stock is considered “underwater” and the option is therefore not worth exercising.

There are two main types companies can offer: incentive stock options (ISO) and non-qualified stock options (NSO), each of which have their advantages and disadvantages. NSOs are more common — as well as more popular from the company’s point of view — and require the employee to pay the taxes both when the stock option is exercised and when the shares are sold. ISOs offer tax benefits to employees who keep their shares for a certain amount of time. This allows them to only pay taxes when the shares are sold, freeing them from the tax burden associated with exercising their stock options.

Conclusion

Administering an equity compensation plan can be challenging for a business. Succession Resource Group provides a robust suite of services for the financial industry and has decades of expertise in the field. If you are exploring your possibilities for offering equity compensation, we can help complete your project efficiently and cost-effectively. Please contact us today for an initial consultation so we can guide you through the process.

David Grau Jr.

Written by David Grau Jr.

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